Going Dutch

On January 17, 1956, the Ford Motor Company did what Henry Ford never wanted it to do: it went public. In the most highly anticipated initial public offering in history, investors shelled out more than six hundred million dollars for 10.2 million shares. The I.P.O. was more than a business transaction. It was a cultural event, the embodiment of what the New York Stock Exchange called “people’s capitalism.” Ford insisted on reserving roughly eighty per cent of the shares for individual investors—as opposed to big institutions—and when the market opened the company suddenly had three hundred and fifty thousand new owners.

Half a century later, another iconic company, the Internet search engine Google, is on the verge of going public, and the hype surrounding its I.P.O. has, if anything, surpassed that which preceded Ford’s. Stock-market pundits predict that the offering could give Google a market value between fifteen and twenty-five billion dollars and resuscitate the I.P.O. market, and the real dreamers believe that it could return the entire technology sector to the “daddy’s rich and mama’s good-looking” days of the late nineties. Google’s I.P.O. might indeed transform things—just not, as the dreamers hope, in Silicon Valley. What it really could change is Wall Street.

It’s an open secret that the current I.P.O. system is broken. As things stand, when a company goes public the investment bank that is underwriting the offering effectively sets the price of the I.P.O., after canvassing big investors to find out how much they’re willing to pay. Then it determines who gets to buy shares. In theory, the system is reasonable enough. In practice, it is deeply flawed, because it creates a conflict of interest between the investment bank and the company. The company wants to get the highest price possible for its stock so that it can raise as much money as possible. The bank has other priorities. It has personal relationships with institutional investors it wants to keep happy. It has clients to reward. If it keeps the offering price down, it can use the I.P.O. shares to curry favor and drum up new business. In the late nineties, for instance, institutional investors channelled trading through the investment banks that let them in on hot I.P.O.s. A recent New York Stock Exchange/N.A.S.D. report concluded that underwriters “had at times engaged in misconduct contrary to the best interests of investors and our markets; at least some of this misconduct was unlawful.”

The victims of all the chicanery were the companies that went public. In 1999 and 2000, they saw their share prices jump by an average of sixty-five per cent on the first day of trading. Those gains went to the lucky investors who got cheap shares, rather than to the companies that were trying to raise money. The finance professors Jay Ritter and Ivo Welch have calculated that in those years new companies raised sixty-six billion dollars less than they would have if the stocks had been priced correctly.

The stock-exchange report suggests tinkering with the system: new regulations, more hoops. But, with so much money at stake, it might be time to take a run at fixing the thing, rather than patching it up with duct tape. The basic problem with the I.P.O. process is that investment banks act as intermediaries between companies and investors. So one solution would seem to be to cut out the middlemen.

That, as it happens, is what Google is contemplating. To be sure, the company has made the rounds on Wall Street and auditioned the usual investment banks. But it is also considering a different approach. Instead of hiring an investment bank, Google would effectively let the market set its share price. The process, which is often called a Dutch auction, is simple. Investors submit bids over the Internet telling the company how many shares they want and at what price. The company then calculates a price at which it can sell all its shares and raise the most money. Investors who bid that price or higher get shares, while those who bid lower do not. The virtue of this system is that no one is rewarded for personal connections—no kickbacks, no quid pro quo. And the company knows that it’s not being shortchanged: the price is that which the market is willing to pay.

A version of this system has been devised by the boutique investment bank W. R. Hambrecht but has been slow to catch on; only a handful of companies have tried it. New companies are wary of challenging Wall Street. Without the legitimacy conferred on them by an investment bank, they worry that big investors will ignore them. They can’t resist going with the devil they know.

Google, though, has nothing to fear. It doesn’t need Wall Street to gin up investor interest or to protect its share price. It has the heft and the prestige to buck the system. What’s more, its approach to business happens to suit the Dutch-auction model. Google became the dominant player in the search-engine market by going directly to the people. When you use Google to find information on the Web, it doesn’t ask a cadre of experts where the information is likely to be. Instead, it turns to the Internet as a whole, essentially asking millions of Web pages to vote. The process is analogous to the new-model I.P.O.: forget the experts; go with the crowd. You might say that Google could Google its own stock price.

In the end, the company may very well decide that going Dutch is too risky, and choose instead to go public the old-fashioned way. But it has already rewritten the rules for one industry. Why not have a go at another?

James Surowiecki is the author of “The Wisdom of Crowds” and writes about economics, business, and finance for the magazine.